Budget 2024: ‘Bracket creep’ will cancel out Hunt’s modest tax cuts
11 March 2024
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10 March 2024
Economic Theory
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The good news in last week’s budget statement is that over the short term the cut in national insurance rates by two percentage points will, as Jeremy Hunt undoubtably hopes, cause the economy to grow a bit faster. Tax cuts can incentivise more work or (where applicable) more savings and investment in capital, and these extra inputs mean higher output. I emphasise “over the short term” because these inputs are subject to diminishing returns, which is why tax cuts do not generate sustained higher rates of economic growth.
That is why, when we focus our attention on particular episodes from the past, we can often see growth accelerating in response to reductions in tax rates, yet when we compare growth rates averaged over long time frames between different countries there is little correlation, negative or positive, with tax burdens or marginal rates.
Furthermore, the respite from higher taxation is itself likely to be very brief. As long as income tax thresholds remain frozen, fiscal drag (I prefer the more ominous-sounding American term ‘bracket creep’) will subject more and more to higher rates of tax and gradually dilute or even reverse the impact of these changes.
This is the second 2p-per-pound cut to national insurance. Prior to the Chancellor’s Autumn Statement back in November, earnings between £12,570 and £50,270 were taxed at a rate of 12%. After the budget announcement last week, this rate will drop to 8%, while the rate above the upper threshold remains fixed at 2%. Meanwhile the thresholds for both NI and income tax remain fixed in place, even as wages and prices are expected to continue to rise. Reducing the marginal rate of tax on earnings for most workers from 32% to 28% may encourage more work effort from those who fall well within the upper and lower thresholds and remain committed to remaining in the workforce. At the same time, depending on the rate of inflation in the years to come, for some low-earners fiscal drag will lower after-tax income, and perhaps encourage a few to join the growing ranks of the economically inactive.
To see how, consider that prior to the two reductions in NI, someone earning half the median salary for full-time employees, or about £17,500 per annum, would (assuming no child tax credits) have paid an average tax rate of 9% – that is, £956 in income tax, and £591 in NI, which is really just income tax 2.0 – leaving them an after-tax income of £15,923. Now suppose the rate of inflation settles down to 3% per annum till 2028 – slightly above the rather optimistic rate of 2% projected by the OBR. If wages merely kept pace with the consequent price rises, this person’s wages would increase to £19,696, NI contributions to £855, and income tax to £1,425. Thanks to the freeze in thresholds, this earner’s average rate of tax would rise to 10%, and though the real value of their pre-tax income would remain unchanged, their after-tax income in real, 2024 prices is only £15,474 – a decline of nearly 3%.
The reduction in NI rates means for this earner an immediate rise in after-tax income of £197 and a reduction in the average tax rate to 8%. Yet, once again assuming a 3% rate of inflation, the amount paid in NI will rise to £570 by 2028. The real value of after-tax income in 2024 prices is £15,727, nearly £200 less than in 2024 prior to the policy announcement, and the average tax rate is 20%. Raise the projected inflation rate to 4% and we get an average tax rate of 12%, with a real-term drop in income of £314.
Contrast this with someone who earns four times as much, £70,000. For them, the benefits from the two drops in NI rates do last – just. These benefits are worth £1,508 in 2024, and even accounting for fiscal drag, by 2028 this earner is still better off by £611 or £340 per annum in 2024 prices, depending on which of the two inflation rates we assume. Even so, for people like this, who earn above the £50,270 threshold but well below the additional 45% rate threshold of £125,140, the marginal rate will remain unchanged at 42% (an income tax rate of 40% plus 2% NI on income above £50,270) as long as moderate rates of inflation prevail. So at the intensive margin, are people already in the labour force likely to adjust the amount of time and effort they devote to work on the basis of these changes to their overall incomes? Probably very few will do so, particularly as at this level of earning potential, state benefits will replace only a small fraction of what people can earn.
Combined with the freeze in fuel duties, the cost in lost revenues from the last of the two 2p cuts to NI is estimated to be about £15 billion. If the Chancellor really had £15 billion to spare (he doesn’t; the debt is projected to carry on rising), he would have done better to abolish – not tinker with, but abolish – stamp duty. Stamp duty discourages people from moving house to seek better economic opportunities. That is one growth-damaging inefficiency. Another inefficiency is the mismatch it creates in the housing sector, discouraging the elderly from downsizing so that young families can purchase the larger houses they need. Such a reform could generate long-term benefits to the economy. Unfortunately, only a small number of people move house between any two elections, so this is the reform that is never implemented.
Prof Michael Ben-Gad is a Professor of Economics at the Department of Economics, City University of London
That is why, when we focus our attention on particular episodes from the past, we can often see growth accelerating in response to reductions in tax rates, yet when we compare growth rates averaged over long time frames between different countries there is little correlation, negative or positive, with tax burdens or marginal rates.
Furthermore, the respite from higher taxation is itself likely to be very brief. As long as income tax thresholds remain frozen, fiscal drag (I prefer the more ominous-sounding American term ‘bracket creep’) will subject more and more to higher rates of tax and gradually dilute or even reverse the impact of these changes.
This is the second 2p-per-pound cut to national insurance. Prior to the Chancellor’s Autumn Statement back in November, earnings between £12,570 and £50,270 were taxed at a rate of 12%. After the budget announcement last week, this rate will drop to 8%, while the rate above the upper threshold remains fixed at 2%. Meanwhile the thresholds for both NI and income tax remain fixed in place, even as wages and prices are expected to continue to rise. Reducing the marginal rate of tax on earnings for most workers from 32% to 28% may encourage more work effort from those who fall well within the upper and lower thresholds and remain committed to remaining in the workforce. At the same time, depending on the rate of inflation in the years to come, for some low-earners fiscal drag will lower after-tax income, and perhaps encourage a few to join the growing ranks of the economically inactive.
To see how, consider that prior to the two reductions in NI, someone earning half the median salary for full-time employees, or about £17,500 per annum, would (assuming no child tax credits) have paid an average tax rate of 9% – that is, £956 in income tax, and £591 in NI, which is really just income tax 2.0 – leaving them an after-tax income of £15,923. Now suppose the rate of inflation settles down to 3% per annum till 2028 – slightly above the rather optimistic rate of 2% projected by the OBR. If wages merely kept pace with the consequent price rises, this person’s wages would increase to £19,696, NI contributions to £855, and income tax to £1,425. Thanks to the freeze in thresholds, this earner’s average rate of tax would rise to 10%, and though the real value of their pre-tax income would remain unchanged, their after-tax income in real, 2024 prices is only £15,474 – a decline of nearly 3%.
The reduction in NI rates means for this earner an immediate rise in after-tax income of £197 and a reduction in the average tax rate to 8%. Yet, once again assuming a 3% rate of inflation, the amount paid in NI will rise to £570 by 2028. The real value of after-tax income in 2024 prices is £15,727, nearly £200 less than in 2024 prior to the policy announcement, and the average tax rate is 20%. Raise the projected inflation rate to 4% and we get an average tax rate of 12%, with a real-term drop in income of £314.
Contrast this with someone who earns four times as much, £70,000. For them, the benefits from the two drops in NI rates do last – just. These benefits are worth £1,508 in 2024, and even accounting for fiscal drag, by 2028 this earner is still better off by £611 or £340 per annum in 2024 prices, depending on which of the two inflation rates we assume. Even so, for people like this, who earn above the £50,270 threshold but well below the additional 45% rate threshold of £125,140, the marginal rate will remain unchanged at 42% (an income tax rate of 40% plus 2% NI on income above £50,270) as long as moderate rates of inflation prevail. So at the intensive margin, are people already in the labour force likely to adjust the amount of time and effort they devote to work on the basis of these changes to their overall incomes? Probably very few will do so, particularly as at this level of earning potential, state benefits will replace only a small fraction of what people can earn.
Combined with the freeze in fuel duties, the cost in lost revenues from the last of the two 2p cuts to NI is estimated to be about £15 billion. If the Chancellor really had £15 billion to spare (he doesn’t; the debt is projected to carry on rising), he would have done better to abolish – not tinker with, but abolish – stamp duty. Stamp duty discourages people from moving house to seek better economic opportunities. That is one growth-damaging inefficiency. Another inefficiency is the mismatch it creates in the housing sector, discouraging the elderly from downsizing so that young families can purchase the larger houses they need. Such a reform could generate long-term benefits to the economy. Unfortunately, only a small number of people move house between any two elections, so this is the reform that is never implemented.
Prof Michael Ben-Gad is a Professor of Economics at the Department of Economics, City University of London
1 thought on “Budget 2024: ‘Bracket creep’ will cancel out Hunt’s modest tax cuts”
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“Reducing the marginal rate of tax on earnings for most workers from 32% to 28% may encourage more work effort from those who fall well within the upper and lower thresholds and remain committed to remaining in the workforce.”
Are you sure you have that right Professor?
My arithmetic has the marginal rate reducing from 40.2% to 36.7%.
Example: if the employer has an extra £113.80p to pay you ‘cos you’re a productive median income worker adding value to the business, then following the changes you will see £72.00p of that income you generate. You’ve lost 36.7% due to income taxation (the combination of Employers NI of 13.8%, Employees NI of 8% and PAYE Income Tax of 20%)
The only way the arithmetic of Professor Michael Ben-Gad stacks up if he can show that Employers’ NI is not incident on the employee. That’s a pretty tough requirement Sir, but if you think you can explain why it’s not incident on the employee, then go for it.
There’s a Nobel waiting for you, ‘cos if you can prove it, then you can prove a whole lot of other interesting suggestions about tax incidence, such as Professor Richard J Murphy’s claim that council tax is incident on the occupier and not the Landlord, and what better intellectual company to keep than the Snippa.